Christine Benz: Bill, I want to talk about fixed income. This has been a vexing area for a lot of investors. I think they look back on the past couple of decades and see that returns have been genuinely very good, in part because we've had this tailwind of declining interest rates, but maybe the next couple of decades won't be so profitable. How would you think about positioning client portfolios at this juncture? What do they look like? What do your client portfolios look like--fixed income?
Dr. William Bernstein: Well, I try not to talk too much about what we do with clients--it's just a confidentiality and a privacy matter. But I've always felt that people should be taking risks on the stock side and not on the bond side. At the end of the day, there are really only two assets. There are risky assets and there are riskless assets, and then there is an exchange rate between them.
And when the exchange rate rises, when stocks get to be cheap, you want to make sure that you don't have to take a haircut on your bonds. So, for example, during '08-'09, if you owned corporate bonds or muni bonds, you took a haircut, because those tanked, to a lesser extent than stocks did, but they still lost money--or even a short-term corporate bond fund probably declined 8% or 10% on a capital value basis. A muni bond fund, even a short muni bond fund, 4% or 5%; the longer funds much worse than that.
So, I've always been a believer in holding a large amount of Treasuries and money markets and CDs because those don't decline in value. What did the best, of course, during the last decline and during the past year, have been long Treasuries.
Benz: Long, yes.
Bernstein: But that doesn't always happen, and I can easily envision a scenario in which they are not a riskless asset anymore. And in a rapidly rising interest rate environment, stocks won't do well at least in the short term, and long Treasuries won't do well, either. So, I've always been a believer in short high-quality fixed-income assets as the riskless part of your asset allocation.
Benz: Because you need that ballast. So how about TIPS? What do you think about TIPS right now and also just long-term as a component of strategic asset allocation?
Bernstein: TIPS are an interesting asset class. TIPS are very risky in the short term. As we found out in '08-'09, the longest TIPS I think lost in the vicinity of around 25%-28% during the crisis. And that was simply because of liquidity factors. Hedge fund managers were dumping whatever they could, and that was part of what they were doing to gain liquidity.
Benz: So that was a buying opportunity actually in TIPS, though, at that point? For a short window.
Bernstein: It was definitely a buying opportunity, but it also illustrates that it is not part of your riskless asset class. They are interesting because they become riskless on a real basis only in the long term. So, they are short-run risky, they are long-run very safe.
So, I see TIPS as a defeasing asset class. In other words, you use it to pay for your living expenses, or offset living expenses at some future date. So I'm not a big believer in buying a TIPS fund. I believe if you're going to buy them, you use them just for that purpose, and you use a ladder. Buy them at 5, 10, 15, 20, 25, 30 years as long as you think your retirement is going to last, and those are sitting there to pay for those living expenses at those points in the future.
Now, the problem with that right now is that they are hardly expensive, and eventually ... we'll have another crisis, eventually for maybe that reason or some other reason, their prices will fall, or yields will rise, and I think when you start seeing yields of 2% at the short end or 2%, 2.2%, 2.5% at the long end, which is where they have been historically, I think, you start picking them up.
Benz: Last thing I want to touch on, Bill, with you is the role of foreign bonds and whether that currency diversification that you get with an unhedged foreign bond or foreign bond fund is worth the extra volatility that you pick up?
Bernstein: No. The riskless part of your portfolio, the bond part of your portfolio, should be truly riskless, and we very recently saw a period during which foreign currencies got very badly hammered during a financial crisis. If we get a European financial crisis, that will almost certainly happen again, and so just when you need the liquidity most will be when the value of these things has declined very rapidly.
Benz: With the hedged products you pick up some extra costs, so I'm guessing that you are not a big fan there, either?
Bernstein: No, I'm really not. It is theoretically possible to gain some diversification value by investing in foreign bonds and then hedging those returns back, but in the long run, that's just way too complicated for most people. It's overkill in terms of complexity.